Doug Cliggott

NEW YORK (CNN/Money) - When Doug Cliggott said at the beginning of 2002 that stocks would be down for a third year in a row, a lot of people thought he was nuts. Now they probably think they were nuts for not listening to him.

Cliggott, who worked at J.P. Morgan at the time, was the only strategist at a major firm who thought that stocks were heading lower. His year-end target on the S&P 500 of 950 was 17 percent below where the market was trading at the end of 2001. His recommendation that investors put just 50 percent of their portfolio into stocks was the lowest on the Street. He'd been bearish on the market since 1999, and he wasn't about to stop.

Standing out in a crowd The S&P 500 started '02 at 1148 and Doug Cliggott was the only strategist who thought the market would be down. Now the S&P is at 885. Strategist  Firm  S&P Target*  Doug Cliggott  J.P. Morgan  950  Jeff Applegate  Lehman Brothers  1350  Rich Bernstein  Merrill Lynch  1200  Abby Joseph Cohen  Goldman Sachs  1300-1425  Steve Galbraith  Morgan Stanley  1225  Tom Galvin  Credit Suisse First Boston  1375  Ed Kerschner  UBS Warburg  1570  Tobias Levkovich  Salomon Smith Barney  1350  Tom McManus  Banc of America Securities  1200  Ed Yardeni  Prudential Securities  1300   * These were strategists' targets for the S&P at the beginning of '02. As stocks have fallen, so have the targets. Galvin and Applegate both left their firms this fall.  Source:  Firms

And then, as the market struggled and people began to realize he might actually have it right, Cliggott pulled a Barry Sanders, leaving J.P. Morgan to head up U.S. research for Swedish-run hedge fund Brummer & Partners. In an age when leaving to "spend more time with my family" has become a euphemism for "fired," Cliggott was doing exactly that, quitting a job that demands you spend tons of time on the road meeting clients. "It's freed up a tremendous amount of time for more research," says Cliggott of his new job. "And it's given me more time to cause trouble at home."

We caught up with Cliggott to ask him what he thinks of the market now that the S&P has fallen to 885. His answer was the same as it's been for four years now: It's way too expensive.

CNN/Money: You thought the market was going to be down this year; most other people didn't. What did you see that they didn't see?

Cliggott: What we thought would happen was that earnings would end up coming pretty far below consensus and that P/E multiples would come under pressure. Those were two real negatives. To be honest, I don't really remember now exactly what consensus earnings expectations were a year ago, but they were a heck of a lot higher than what we actually got. And even though bond yields are low, we've continued to see meaningful downward pressure on P/E multiples.

CNN/Money: So now that the market has come below your year-end target of 950, should we be loading up on stocks?

Cliggott: I don't think so -- basically for the same reasons as a year ago. Looking at earnings expectations for '03, the consensus has operating earnings growth by about 13 percent for the S&P 500. My guess is we'll be lucky if it's zero, and it may in fact be slightly negative. P/E multiples, either on operating earnings or reported net income [earnings according to generally accepted accounting principles], still look extraordinarily high. So I think we're probably going to see further downward pressure on P/E multiples.

CNN/Money: What kind of earnings do you look at? The operating earnings that companies and Wall Street analysts use? Or reported earnings?

Cliggott: You know the expression mulligan golf? A mulligan is when you hit a drive into the water or a sand trap -- you just completely blow it -- and you call a mulligan and you don't count it. When it's a friendly game and it's no money, you can play that way. It strikes me that operating earnings are the same as mulligan golf. You build some inventory you wish you hadn't, you build a factory you wish you hadn't, so you shout mulligan and you don't count it. But it does count. It is real money -- shareholders' money. The alternative is to use reported net income. But that can overstate weakness in down cycles, and overstates strength at the peak.

So I've come to think the best thing to do is this: If you look at the two measures of earnings over a long period of time, it turns out that reported net income averages about 85 percent of operating income. So for valuation work, use 85 percent of operating earnings. If you do that you get operating earnings of about $40 for this year on the S&P 500.

Looking at history, about 16 times earnings is right. So I think fair value on the S&P is something like 640. I don't think we get there next year. All the liquidity that's being fed into the system [fiscal stimulus, low interest rates] is a strong current in the other direction. I don't think it's strong enough to lift the market but it's enough to keep us from going in a straight line down to fair value. And keep in mind that fair value is a moving target. I'd like to think that in two or three years earnings will be higher than $40. That would put upward pressure on fair value.

CNN/Money: On a sector basis, last year you favored health care, consumer staples and energy. Consumer staples worked out well, energy worked out well, but health care didn't turn out so well. What sectors would you emphasize now and what would you avoid?

Sector snapshot Consumer staples have been the best performing stocks in the S&P 500 this year; tech and telecom are the worst. Sector  Year-to-date  Consumer Discretionary  -24%  Consumer Staples  -6%  Energy  -12%  Financials  -15%  Health Care  -20%  Industrials  -27%  Information Technology  -36%  Materials  -8%  Telecom Services  -34%  Utilities  -33%   Source: Standard & Poor's

Cliggott: I'd probably emphasize the same three. The logic last year was looking for industries where either earnings expectations were very, very modest, as was the case in energy, or looking for sectors that aren't very economically sensitive -- classically, health care and consumer staples. My logic on '03 is similar -- earnings growth and, I think probably economic growth, will surprise to the downside -- which gives you a case to continue to own staples and health care. The energy story is very different now: Everybody is looking for growth in energy earnings but probably underestimating the growth given where commodity prices are now. With crude oil trading at over $31 [a barrel] and some firmness in natural gas prices, it seems that expectations for a lot of energy companies are maybe too cautious.

I'd avoid the most economically sensitive areas: technology, financials and consumer discretionary.

CNN/Money: What would it take to make you bullish?

Cliggott: The most important fundamental is price, so a much lower price would be the main thing. I'd also like to see a period of much, much lower volatility, so that you can make a case of a lower equity-risk premium. But volatility is frighteningly high in the equity market which I think will continue to drive investors away. As for earnings, it's hard for me to imagine an economic outcome that would generate enough growth to justify a current stock price levels.